revenue bond

Let's assume ABC Town wants to build a new toll road, but it doesn't have the money to fund the construction. It could issue revenue bonds, and the tolls collected from the toll road would fund the interest and principal payments. If the revenue from the toll road is insufficient, ABC Town might not be able to make timely interest and principal payments. In many cases, revenue bond issuers can avoid or delay interest payments if a minimum amount of revenue is not generated from the project.

Revenue-bond holders generally have no claim to the project’s assets (i.e., they cannot repossess the toll road if it does not generate the promised interest and principal payments). Revenue bonds may also have catastrophe call provisions, which allow the issuer to call the bonds if the revenue-producing facility is destroyed. Thus, revenue bonds generally warrant a higher yield than general obligation bonds to compensate for these added risks.

Revenue bonds usually have $1,000 or $5,000 face values. They usually pay interest semiannually, although some are zero-coupon bonds. Typical maturities are one to 30 years. Many are serial bonds, and many are callable or putable, and some have unusual payment schedules. The issuer sets forth the terms of the debt in the indenture agreement.

Revenue bonds are typically issued the same way corporate bonds are: through an underwriter that presents a written prospectus to buyers and facilitates a competitive bidding process. After the bonds begin trading, municipal bond dealers across the country earn spreads by acting as intermediaries between buyers and sellers. Although purchasing specific revenue bonds and other municipal bonds gives investors direct control over which bonds they hold and the location of the issuers (thus maximizing tax advantages), mutual funds and municipal bond investment trusts are the most common way to invest in revenue bonds and other municipal bonds.

Municipal bonds, in general, rank between agency bonds and corporate bonds in risk and return. As with all debt, they are subject to credit, interest-rate, call, and market risk. To mitigate default risk, some issuers carry private insurance on their bonds (investors can also purchase this insurance). In some cases, a federal agency might guarantee or insure a revenue bond issue. Some issuers also back their bonds with a commercial bank letter of credit or escrow funds.